Tuesday, October 12, 2010

Why is FASB Reconsidering Mark- to-Market?

The Financial Accounting Standards Board (FASB) is looking into a possible reimplementation of the mark to market rules that just about destroyed the financial system in 2008. How is it possible that they would even reconsider this concept? Didn't the recent flash crash further remind us that markets can be very irrational short term? Markets can and will become disconnected from the financial benefits of the instruments they track. In some instances they can be an indicator of future cash flows of the fixed income instruments they track, but do we really want to use a system proven to be wildly inaccurate just because the other main option gives management leeway to manipulate data.

Data manipulation falls into the category of fraud and hence the management team can be fired and prosecuted. All detriments to widespread adoption of false reporting. Why doesn't the FASB instead work on solutions that would reduce the ability to engage in fraudulent reporting? Instead they are focused on a system that has no solution when markets go awry like in the financial crisis from 2007-09. Banks were left recording huge unrealized loses on instruments that ultimately paid off. Instruments that never quit paying. Maybe a system where companies record results based on the economic situation, but they 'highlight' how the market is trading the instruments. It could highlight to investors the risks with the company, but it wouldn't require unnecessary capital raises.

Supposedly the mark to market system was implemented so investors could be protected from fraud but instead we got diluted to oblivion as bank after bank had to raise capital at the lows of the market. The repeal of the literal implementation of the law is likely what created the bottom in March 2009. When companies where able to quit taking loses on illiquid and forced trades, the market turned on a dime. Why is FASB even rethinking this issue? Any meaningful implementation will be bad for the markets.

One of our favorite analysts (actually a hedge fund manager now) Tom Brown wrote a great letter to FASB that he posted on bankstocks.com. The details on State Street is the paramount problem with mark to market. How are investors protected if the system can cause a 59% decline in a stock price? All for a charge that wasn't real. Especially considering the potential dilution. Its one thing to have your stock drop, but it's a completely different one for it to be diluted to heck because of a bad rule. You'll never recover that investment once its diluted at the bottom.

In the fullness of time, furthermore, we now know that the collapse in prices during the credit crunch was largely irrational and the attendant charges to capital pointless. There’s no shortage of examples to illustrate this, but one that stands out is State Street’s experience after it reported its earnings for the fourth quarter of 2008. In the report, the company disclosed additional losses of $3 billion in its fixed income portfolio. The losses arose entirely from the credit panic, not from credit issues in the portfolio itself. Still, speculation immediately arose that the company would have to do a big capital raise to shore up its financial ratios, which in turn put enormous pressure on its stock. The more the stock fell, the larger the estimate became of how many new shares the company would have to issue, which in turn pressured the stock even further. Result: thanks to the bogus “loss” State Street had to report, its stock dropped by 59% in a single session. All because of a misguided accounting rule. Since then, we now know that the company’s fixed-income portfolio encountered no undue credit problems. As the credit markets have recovered, the company has reversed that entire fourth-quarter charge. What, exactly, is the point? 
FASB requested feedback by September 30th so it'll be interesting to see what comes of their proposals. Unfortunately they seem uninterested in listening to investors even though they are they people most impacted by these rules. Check out marktomarketdebate.com for more info on the debate. Stay tuned as the debate heats up.

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